When Gears of War debuted Nov. 12 to critical acclaim and frenetic fandom, it was the culmination of a years-long strategy for Microsoft to gain credibility in the videogame industry. And it was just in the nick of time to make the Xbox 360 look good, as Sony and Nintendo launched their consoles. It was proof that Microsoft could live up to its promise of launching second-generation 360 games, just as the rivals launched their first-generation titles.

One game isn’t going to win the console war, but Microsoft’s newest hit will keep its console in the limelight at a critical time when gamers are deciding where to invest their hard-earned dollars. Gears of War arrives just as Microsoft has plenty of consoles available in the market, while at least one of its competitors is supply-constrained. As such, the game is one more piece of evidence that Microsoft is executing according to its plans. It remains to be seen if gamers will anoint Microsoft the console king, or if the 360 is doomed to fall behind, now that it is no longer the freshest lettuce on the shelf.

The string of on-time results with the 360 makes Microsoft seem accidentally brilliant. After all, it was an accident, because Microsoft had no clue about when Epic Games would really finish the game. Cliff “CliffyB” Blezinski, the lead designer at Epic Games, proposed his concept for Gears of War in 2002. It turned into four years of effort, $10 million in development costs and a marquee title.

And when Microsoft launched the 360 last fall, its executive team really didn’t know that they would beat Sony’s PlayStation 3 by a year. Now, as Microsoft enters its second holiday season, it has more than 160 games available, while Sony will struggle to get 22 out by year’s end, and Nintendo shoots for 32 games on the Wii. Microsoft has a permanent advantage over Sony in this generation.

“In the last generation, we were late and our box was more expensive to build,” said Bill Gates, former chairman of Microsoft, on a recent visit to the TechNet conference in Silicon Valley. “We said this generation we we’re not going to repeat that. We traded positions with Sony. We came out a year before them. We have lower costs and a sleek box.”

Sony’s $600 version of the PS3 is indeed more expensive to produce, with an estimated manufacturing cost of $840, according to a “tear down” analysis by market research firm iSuppli. The same company estimates that the 360 now only costs $323 to manufacture. The cost difference is important, because Microsoft is in a position to introduce price cuts that could drive Sony deeper into the red. In its most recent quarter, ended Sept. 30, Sony’s earnings fell 94 percent to $14.4 million because of costs related to its laptop battery recall. It also reported a $369 million operating loss in its videogame business due to PS3 start-up costs. Sony has $4.7 billion in cash and $3 billion in short- and current long-term debt.

Meanwhile, Microsoft has $31.8 billion in cash. The Entertainment and Devices division, which includes games, grew its sales for the most recent quarter by 70 percent, to $1.03 billion. The division lost $96 million, down from a loss of $173 million. Even if all of its other businesses were just breaking even, Microsoft could lose that much money for 80 years before it ran out of money.

Robbie Bach, president of the E&D division, says Microsoft has no intention of just bleeding Sony to death. His goal is to make the division profitable through smart thinking, not brute force. He says the division is on target to hit profitability by June 30, 2008. In the last generation, Microsoft lost an unimaginable $168 per box, or about $3.7 billion altogether. It burdened every machine with a $40 to $50 hard disk drive, making the hardware too expensive to ever break even. This time, Microsoft balanced its system better, toning down the technology in the name of shaving costs.

Bach says things are coming together. Xbox Live is years ahead of Sony, with more than 4 million active members, he says. Microsoft has also launched its $199 HD-DVD add-on accessory to compete with the PS3’s ability to play Blu-Ray high-definition movies. Microsoft has begun a service to allow 360 owners to download movies and TV shows onto their consoles. And with a new update, the 360 can now display games in the same 1080p resolution the PS3 uses. “As far as technology goes, it’s a wash,” Bach says.

Sony’s executives say they’re just getting started.

“If you look at our launch titles, our lineup looks very good compared to what Microsoft has,” said Phil Harrison, head of Sony’s worldwide game studios.

But Sony has plenty to worry about. At the very least, industry executives and analysts believe Microsoft will gain market share in the newest generation of consoles. And if Sony and Nintendo fail to execute, Microsoft might have a chance to take the lead.

“Sony could go from first to third,” said David Cole, an analyst at DFC Intelligence in San Diego, CA. “Clearly, it will be a much closer race this time.”

But it’s too early to count anyone out. Both Sony and Nintendo were able to delay their own launches of next-generation consoles because their profits were being fueled by the launch of new handhelds. In 2005, those handhelds accounted for the bulk of the growth in the market, allowing Sony and Nintendo to hang on to a lot of the industry’s profit. In 2006, the Xbox 360 has fueled a lot of growth in revenues, but Microsoft hasn’t been able break into the black. Meanwhile, Sony is enjoying a lot of residual sales for games on the PlayStation 2, which has been outselling the Xbox 360.

Some of the company’s big first-party titles, such as Crackdown, Too Human and Mass Effect, have slipped in production, and won’t be released until 2007. The dearth of first-party titles reflects the fact that Microsoft has the smallest internal development team among the console makers. It has about 1,200 game developers, while Sony has 2,500, Nintendo has an estimated 1,500 and Electronic Arts has more than 5,500. It will be hard for Microsoft to beat its rivals if it doesn’t have enough soldiers on the battlefield.

Microsoft has also failed to take advantage of its lead as much as it could have. A big shortage of memory chips hamstrung production in 2005, and poor quality on the initial units forced Microsoft to make an embarrassing admission 10 months after the launch: Units made before 2006 were so poorly constructed, Microsoft promised to offer free repairs to anyone who had problems with an early console. And while Microsoft promised to hit 10 million units before Sony sold one, the company only had sold six million units – shipped into the distribution system – as of Sept. 30. Clearly, there has been a lot of friction that has held back Microsoft from cementing a huge early lead.

P.J. McNealy, an analyst at American Technology Research, says Microsoft’s production problems are behind it, and he estimates it could sell 10 million to 11 million consoles by the end of the year. By comparison, he thinks Sony will be lucky to ship two million consoles, while Nintendo could move four million Wii machines. Thanks to its long head start, McNealy said Microsoft will still be ahead of Sony by the end of 2007.

Technological obsolescence is one of the greatest threats facing the 360. Sony’s Blu-Ray games are already using a lot more capacity on a disk than Microsoft’s games are. That means Sony’s games could eventually surpass Microsoft’s in depth. Even if that never comes to pass in the 360’s five-year lifespan, Sony is trying mightily to convince gamers that the 360 is yesterday’s technology. Kaz Hirai, CEO of Sony Computer Entertainment America, contends that the PS3 is “future proofed” for the next 10 years, thanks to Blu-Ray and the Cell processor.

Nintendo remains the biggest wild card. It has executed better on its launch than either Microsoft or Sony did. By focusing on easily manufacturable low-end technology, Nintendo was able to ensure a huge supply of Wiis for its first holiday season. Cole believes Nintendo will be able to hit its target of four million units worldwide by the end of 2006. And Nintendo has a fighting chance to expand the market to non-gamers, says Robin Kaminsky, head of North American publishing for Activision.

Shane Kim, head of Microsoft Game Studios, says Microsoft is also trying to expand the market to non-gamers. That was why Microsoft’s Rare studio worked for years on Viva Piñata, a kid-oriented game with cute piñata animals. However, Nintendo is certain to offer many more titles that appeal to non-gamers. While Microsoft seems obsessed with taking away gamers from Sony, Nintendo may have the more elevated plan of expanding the market for games. If that strategy works, it may pull ahead of its rivals.

But Nintendo’s newfound competitiveness could also help Microsoft. Moore has acknowledged the value of the “Wii60” psychology among gamers who realize that they could buy two consoles for the price of the PS3.

In some sense, the battle for the next-generation consoles seems harder to call than ever. But looking at Microsoft’s challenges in 2006 and comparing them to the challenges of launching the Xbox in 2001, it’s clear the company has come a long way. There are still big elements of Microsoft’s strategy that have yet to play out. Halo 3 is expected to launch next year, and Microsoft will debut its “Live Anywhere” communications system to leverage the PC, 360 and cell phones. With such prospects to come, neutral parties like Electronic Arts continue to throw considerable support behind the 360, even as they ramp up support for the other consoles.

“By being No. 2, we got the chance to play again,” said Gates. “Our credibility is strong with developers and publishers. Now with the Xbox 360, we’re playing with different rules based on what we’ve learned.”

Dean Takahashi is author of The Xbox 360 Uncloaked, available at www.spiderworks.com. Write him at [email protected].

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